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a simple model of price formation

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K. SznajdWeron , R. Weron

pl. Maxa Borna 9, 50-204 Wroclaw, Poland

Hugo Steinhaus Center, Wroclaw University of Technology,

Wyspianskiego 27, 50-370 Wroclaw, Poland

A simple Ising spin model which can describe the mechanism of price formation in nancial markets

is proposed. In contrast to other agent-based models, the inuence does not ow inward from the

surrounding neighbors to the center site, but spreads outward from the center to the neighbors. The

model thus describes the spread of opinions among traders. It is shown via standard Monte Carlo

simulations that very simple rules lead to dynamics that duplicate those of asset prices.

PACS numbers: 05.45.Tp, 05.50.+q, 87.23.Ge, 89.90.+n

distribution [15,16].

Instead of looking at the central part of the distribution, an alternative way is to look at the tails. Most

types of distributions can be classified into three categories: 1 thin-tailed for which all moments exist and

whose density function decays exponentially in the tails;

2 fat-tailed whose density function decays in a powerlaw fashion; 3 bounded which have no tails.

Virtually all quantitative analysts suggest that asset

returns fall into the second category. If we plot returns

against time we can notice many more outlying (away

from the mean) observations than for white noise. This

phenomenon can be seen even better on normal probability plots, where the cumulative distribution function

(CDF) is drawn on the scale of the cumulative Gaussian distribution function. Normal distributions have the

form of a straight line in this representation, which is approximately the case for the distribution of weekly or

monthly returns. However, distributions of daily and

higher-frequency returns are distinctly fat-tailed [17].

This can be easily seen in the top panels of Fig. 1, where

daily returns of the DJIA index for the period Jan. 2nd,

1990 Dec. 30th, 1999, are presented.

Clustering and dependence. Despite the wishes of

many researchers asset returns cannot be modeled adequately by series of iid (independent and identically

distributed) realizations of a random variable described

by a certain fat-tailed distribution. This is caused by

the fact that financial time series depend on the evolution of a large number of strongly interacting systems and belong to the class of complex evolving systems. As a result, if we plot returns against time

we can observe the non-stationarity (heteroscedasticity) of the process in the form of clusters, i.e. periods during which the volatility (measured by standard

deviation or the equivalent l1 norm [18]) of the process is much higher than usual, see the top-left panel

of Fig. 1. Thus it is natural to expect dependence

in asset returns. Fortunately, there are many methods to quantify dependence. The direct method consists in plotting the autocorrelation function: acf (r, k) =

PN

PN

)(rtk r)/ t=1 (rt r)2 , where N is the

t=k+1 (rt r

used models of statistical mechanics. Its simplicity (binary variables) makes it appealing to researchers from

other branches of science including biology [1], sociology

[2] and economy [38]. It is rather obvious that Isingtype models cannot explain origins of very complicated

phenomena observed in complex systems. However, it

is believed that these kind of models can describe some

universal behavior.

Recently, an Ising spin model which can describe the

mechanism of making a decision in a closed community

was proposed [9]. In spite of simple rules the model exhibited complicated dynamics in one and two [10] dimensions. In contrast to usual majority rules [11], in

this model the influence was spreading outward from the

center. This idea seemed appealing and we adapted it

to model financial markets. We introduced new dynamic

rules describing the behavior of two types of market players: trend followers and fundamentalists. The obtained

results were astonishing the properties of simulated

price trajectories duplicated those of analyzed historic

data sets. Three simple rules led to a fat-tailed distribution of returns, long-term dependence in volatility and

no dependence in returns themselves.

We strongly believe that this simple and parameter free

model is a good first approximation of a number of real

financial markets. But before we introduce our model we

review some of the stylized facts about price formation

in the financial markets.

Stylized facts. Adequate analysis of financial

data relies on an explicit definition of the variables under study. Among others these include the price and the

change of price. In our studies the price xt is the daily

closing price for a given asset. The change of price rt

at time t is defined as rt = log xt+1 log xt . In fact,

this is the change of the logarithmic price and is often

referred to as return. The change of price, rather than

the price itself, is the variable of interest for traders (and

researchers as well).

Fat-tailed distribution of returns. The variety of

opinions about the distributions of asset returns and their

generating processes is wide. Some authors claim the

distributions to be close to Paretian stable [12], some to

1

PN

sample length and r = N1 t=1 rt , for different time lags

k. For most financial data autocorrelation of returns dies

out (or more precisely: falls into the confidence interval

of Gaussian random walk) after at most a few days and

long-term autocorrelations are found only for squared or

absolute value of returns [1820], see bottom panels of

Fig. 1. Recall that for Brownian motion the classical

model of price fluctuations [19,21] autocorrelations of

rt , rt2 and |rt | are not significant for lags greater or equal

to one.

a double-logarithmic paper. Linear regression yields the

Hurst exponent H, whose value can lie in one of the three

regimes: 1 H > 0.5 persistent time series (strict long

memory), 2 H = 0.5 random walk or a short-memory

process, 3 H < 0.5 anti-persistent (or mean-reverting)

time series. Unfortunately, no asymptotic distribution

theory has been derived for the R/S and DFA statistics

so far. However, it is possible to estimate confidence intervals based on Monte Carlo simulations [23].

The model. Recently a simple model for opinion

evolution in a closed community was proposed [9,10]. In

this model (called USDF) the community is represented

by a horizontal chain of Ising spins which are either up or

down. A pair of parallel neighbors forces its two neighbors to have the same orientation (in random sequential

updating), while for an antiparallel pair, the left neighbor takes the orientation of the right part of the pair,

and the right neighbor follows the left part of the pair.

In contrast to usual majority rules [11], in the USDF

model the influence does not flow inward from the surrounding neighbors to the center site, but spreads outward from the center to the neighbors. The model thus

describes the spread of opinions. The dynamic rules lead

to three steady states: two ferromagnetic (all spins up or

all spins down) and one antiferromagnetic (an up-spin is

followed by a down-spin, which is again followed by an

up-spin, etc.).

In this paper we modify the model to simulate price

formation in a financial market. The spins are interpreted

as market participants attitude. An up-spin (Si = 1)

represents a trader who is bullish and places buy orders,

whereas a down-spin (Si = 1) represents a trader who

is bearish and places sell orders. In our model the first

dynamic rule of the USDF model remains unchanged,

i.e. if Si Si+1 = 1 then Si1 and Si+2 take the direction

of the pair (i,i+1). This can be justified by the fact

that a lot of market participants are trend followers and

place their orders on the basis of a local gurus opinion.

However, the second dynamic rule of the USDF model

has to be changed to incorporate the fact that the absence

of a local guru (two neighboring spins are in different

directions) causes market participants to act randomly

rather than make the opposite decision to his neighbor:

if Si Si+1 = 1 then Si1 and Si+2 take one of the two

directions at random.

Such a model has two stable states (both ferromagnetic), which is not very realistic for a financial market.

Fortunately, trend followers are not the only participants

of the market [27]. There are also fundamentalists players that know much more about the system and have a

strategy (or perhaps we should call them rationalists).

To make things simple, in our model we introduce one

fundamentalist. He knows exactly what is the current

difference between demand and supply in the whole system. If supply is greater than demand he places buy

orders, if lower sell orders.

It is not clear a priori how to define the price in a

0.08

0.999

0.99

Returns

0.04

CDF

0.90

0.50

0.10

0.04

0.08

0.01

0.001

500

Days

0.05

0.05

1

ACF

ACF

0.8

0.8

0.6

0.6

0.4

0.4

0.2

0.2

0

0.2

0

0

Returns

0

10

20

30

40

Time lag (days)

50

0.2

0

10

20

30

40

Time lag (days)

50

index during the last decade (top left), normal probability plot

of DJIA returns (top right), lagged autocorrelation function

of DJIA daily returns (bottom left), and lagged autocorrelation function of absolute value of DJIA daily returns (bottom

right). Dashed horizontal lines represent the 95% condence

interval of a Gaussian random walk.

the power spectrum analysis, also known as the frequency domain analysis. One of the most often used

techniques was proposed by Geweke and Porter-Hudak

[22] (GPH) and is based on observations of the slope of

the spectral density function of a fractionally integrated

series around the angular frequency = 0. A simple

linear regression of the periodogram In (a sample analogue of the spectral density) at low Fourier frequencies

k : log{In (k )} = a dlog{4 sin2 (k /2)} + k yields the

differencing parameter d = H 0.5 through the rela The GPH estimate of the Hurst exponent

tion d = d.

H has well known asymptotic properties and allows for

construction of confidence intervals [22,23].

Yet another method is the Hurst R/S analysis [24,25]

or its younger sister the Detrended Fluctuation Analysis (DFA) [26]. Both methods are based on a similar

algorithm, which begins with dividing the time series

(of returns) into boxes of equal length and normalizing

the data in each box by subtracting the sample mean

(R/S) or a linear trend (DFA). Next some sort of volatility statistics is calculated (rescaled range or mean square

curve xt (see Fig. 2) after it is shifted (incremented by

one) to make it positive. Alternatively we could have defined the up-spin to be equal to two and the down-spin

to zero. However, this would have made the calculations more difficult and the description of the model less

appealing.

In Figure 3 we present daily returns and normal probability plots for the simulated (left panels) and USD/DEM

exchange rate (right panels) time series. Without prior

knowledge as to the magnitude of historical returns it is

impossible to judge which process is real and which is a

fraud. The same is true for the simulated and the DJIA

returns of Fig. 1.

should go up, when there is more demand than supply,

and vice versa. For simplicity, we define the price xt in

our model as the normalized differencePbetween demand

N

and supply (magnetization): xt = N1 i=1 Si (t), where

N is the system size. Note that xt [1, 1], so |xt | can be

treated as probability. Now we can formulate the third

rule of our model: the fundamentalist will buy (i.e. take

value 1) at time t with probability |xt | if xt < 0 and sell

(i.e. take value 1) with probability |xt | if xt > 0.

The third rule means that if the system will be close

to the stable state all up, the fundamentalist will place

sell orders with probability close to one (in the limiting

state exactly with probability one) and start to reverse

the system. So the price will start to fall. On the contrary, when r will be close to 1, the fundamentalist will

place buy orders (take the value 1) and the price will

start to grow. This means that ferromagnetic states will

not be stable states anymore.

Results. To investigate our model we perform a

standard Monte Carlo simulation with random updating.

We consider a chain of N Ising spins with free boundary

conditions. We were usually taking N = 1000, but we

have done simulations for N = 10000 as well. We start

from a totally random initial state, i.e. to each site of

the chain we assign an arrow with a randomly chosen

direction: up or down (Ising spin).

0.1

0.04

Returns

Returns

0.05

0.02

0.05

0.02

0.1

0.999

0.99

500

1000 1500

Days

2000

0.04

0.999

0.99

CDF

0.90

0.90

0.50

0.50

0.75

0.10

0.10

0.9

0.7

0.01

0.001

0.01

0.001

0.8

0.65

0.7

0.6

0.6

500

1000 1500

Days

USD/DEM

2000

0.5

500

1000 1500

Days

0

Returns

0.05

1000 1500

Days

2000

CDF

0.02

0

Returns

0.02

daily returns of the USD/DEM exchange rate during the last

decade, respectively (top panels). Normal probability plots of

rt and USD/DEM returns, respectively, clearly showing the

fat tails of price returns distributions (bottom panels).

0.55

Simulation

0.5

0.05

500

2000

and the USD/DEM exchange rate, respectively.

for the simulated (left panels) and USD/DEM exchange

rate (right panels) time series. Again the properties of

the simulated price process duplicate those of historical

data. The lagged autocorrelation of returns falls into

the confidence interval of Gaussian random walk immediately, like for the dollar-mark exchange rate. The same

plot for the DJIA returns shows a bit more dependence.

This can be seen also in Table 1, where values and

significance of the R/S, DFA and GPH statistics for the

simulated and four historical data sets are presented. In

all but one case (DFA for DJIA) the Hurst exponents

of daily returns are insignificantly different from those

of white noise. On the other hand, the Hurst exponents

of the absolute value of daily returns are persistent in

all cases, with the results being significant even at the

two-sided 99% level. Moreover, the estimates of H from

the simulation are indistinguishable from those of real

market data.

In our simulations each Monte Carlo step (MCS) represents one trading hour; eight steps constitute one trading day. We typically simulate 20000 MCSs, which corresponds to 2500 trading days or roughly 10 years. We

chose such a period of time, because in this paper we compare the empirical results with historical data sets (two

FX rates and two stock indices) of about the same size:

2245 daily quotations of the dollar-mark (USD/DEM) exchange rate for the period Aug. 9th, 1990 Aug. 20th,

1999 (see Fig. 2 and Table 1), 2809 daily quotations

of the yen-dollar (JPY/USD) exchange rate for the period Jan. 2nd, 1990 Feb. 28th, 2001 (see Table 1),

2527 daily quotations of the Dow Jones Industrial Average (DJIA) index for the period Jan. 2nd, 1990 Dec.

30th, 1999 (see Fig. 1), and 1561 daily quotations of the

WIG20 Warsaw Stock Exchange index (based on 20 blue

chip stocks from the Polish capital market) for the period

Jan. 2nd, 1995 Mar. 30th, 2001 (see Table 1).

1

ACF

0.8

0.6

0.6

0.4

0.4

0.2

0.2

0

0.2

0

0

10

20

30

40

Time lag (days)

50

0.2

0

10

20

30

40

Time lag (days)

50

1

ACF

ACF

0.8

0.8

0.6

0.6

0.4

0.4

0.2

0.2

0

0.2

0

[13] R.C. Blattberg, N. Gonedes, J. Business 47 (1974) 244.

[14] E. Eberlein, U. Keller, Bernoulli 1 (1995) 281.

[15] J.R. Calderon-Rossel, M. Ben-Horim, J. Intern. Business

Studies 13 (1982) 99.

[16] R. Mantegna, H.E. Stanley, Phys. Rev. Lett. 73 (1994)

2946.

[17] U.A. M

uller, M.M. Dacorogna, R.B. Olsen, O.V. Pictet,

M. Schwarz, C. Morgenegg, J. Banking & Finance 14

(1990) 1189.

[18] D.M. Guillaume, M.M. Dacorogna, R.R. Dave, U.A.

M

uller, R.B. Olsen, O.V. Pictet, Finance Stochast. 1

(1997) 95.

[19] A. Weron, R. Weron, Financial Engineering: Derivatives

Pricing, Computer Simulations, Market Statistics, (in

Polish), WNT, Warsaw, 1998.

[20] R. Weron, Physica A 285 (2000) 127.

[21] L. Bachelier, Theorie de la speculation, Annales Scientiques de lEcole Normale Superieure III-17 (1900) 21.

[22] J. Geweke, S. Porter-Hudak, J. Time Series Analysis 4

(1983) 221.

[23] R. Weron, cond-mat/0103510 (2001).

[24] H.E. Hurst, Trans. Am. Soc. Civil Engineers 116 (1951)

770.

[25] B.B. Mandelbrot, J.R. Wallis, Water Resources Res. 5

(1969) 967.

[26] C.-K. Peng, S.V. Buldyrev, S. Havlin, M. Simons, H.E.

Stanley, A.L. Goldberger, Phys. Rev. E 49 (1994) 1684.

[27] P. Bak, M. Paczuski, M. Shubik, Physica A 246 (1997)

430.

ACF

0.8

0

10

20

30

40

Time lag (days)

50

0.2

0

10

20

30

40

Time lag (days)

50

USD/DEM returns, respectively (top panels). Lagged autocorrelation functions of absolute value for the same data sets

(bottom panels). Dashed horizontal lines represent the 95%

condence interval of a Gaussian random walk.

three simple rules of our model lead to a fat-tailed distribution of returns, long-term dependence in volatility

and no dependence in returns themselves as observed for

market data. Thus we may conclude that this simple

model is a good first approximation of a number of real

financial markets.

We gratefully acknowledge critical comments of an

anonymous referee, which led to a substantial improvement of the paper.

TABLE I. Estimates of the Hurst exponent H for simulated and market data.

Data

Simulation

USD/DEM

JPY/USD

DJIA

WIG20

[2] F. Schweitzer, J.A. Holyst, Eur. Phys. J. B 15 (2000) 723.

[3] R. Savit, R. Manuca, R. Riolo, Phys. Rev. Lett. 82 (1999)

2203.

[4] A. Cavagna, J.P. Garrahan, I. Giardina, D. Sherrington,

Phys. Rev. Lett. 83 (1999) 4429.

[5] D. Chowdhury , D. Stauer, Eur. Phys. J. B 8 (1999)

477.

[6] R. Cont and J. P. Bouchaud, Macroeconomic Dyn. 4

(2000) 170.

[7] D. Challet, M. Marsili, R. Zecchina, Phys. Rev. Lett. 84

(2000) 1824.

[8] V.M. Eguiluz, M.G. Zimmermann, Phys. Rev. Lett. 85

(2000) 5659.

[9] K. Sznajd-Weron, J. Sznajd, Int. J. Mod. Phys. C 11,

No. 6 (2000).

[10] D. Stauer, A.O. Sousa, S. Moss de Oliveira , Int. J.

Mod. Phys. C 11, No. 6 (2000).

[11] J. Adler, Physica A 171, 453 (1991).

[12] See eg. S. Rachev, S. Mittnik, Stable Paretian Models

Simulation

USD/DEM

JPY/USD

DJIA

WIG20

Method

DFA

GPH

Returns

0.5270

0.4666

0.3653

0.5127

0.5115

0.6154

0.5353

0.5303

0.5790

0.4585

0.4195

0.3560

0.5030

0.4981

0.4604

Absolute value of returns

0.8940

0.9335

0.8931

0.7751

0.8406

0.8761

0.8576

0.9529

0.9287

0.7838

0.9080

0.8357

0.9103

0.9494

0.8262

R/S-AL

,

and denote signicance at the (two-sided) 90%, 95%

and 99% level, respectively. For the R/S-AL and DFA statistics inference is based on empirical Monte Carlo results of

Weron [23], whereas for the GPH statistics on asymptotic

distribution of the estimate of H [22].

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